1. Principles of
Chapter 16 Corporate Finance
Tenth Edition
Payout Policy
Slides by
Matthew Will
McGraw-Hill/Irwin Copyright © 2011 by the McGraw-Hill Companies, Inc. All rights reserved.

2. 16-2
Topics Covered
 Facts About Payout
 How Firms Pay Dividends and Repurchase Stock
 How Do Companies Decide on Payouts?
 Information in Dividends and Stock Repurchases
 The Payout Controversy
 The Rightists
 Taxes and the Radical Left
 The Middle of the Roaders

3. 16-3
Payout Policies

4. 16-4
Dividend & Stock Repurchases
U.S. Data 1980 - 2008
1200
1000
Dividends Repurchases Remaining earnings
800
600
$ Billions
400
200
0
-200
-400
-600
-800
80
82
84
86
88
90
92
94
96
98
00
02
04
06
08
19
19
19
19
19
19
19
19
19
19
20
20
20
20
20

5. 16-5
Dividend Payments
April 15, 2009 May 11, 2009 May 13, 2009 June 10, 2009
Exxon Mobil Dividend will be paid Dividend checks
declares regular Shares start to to shareholders are mailed
quarterly dividend trade ex dividend. registered to shareholders.
of $.42 per share. on this date.
Declaration Ex-dividend Record Payment
Date Date Date Date

6. 16-6
Types of Dividends
Cash Dividend
Regular Cash Dividend
Special Cash Dividend
Stock Dividend
Stock Repurchase (4 methods)
1. Buy shares on the market
2. Tender Offer to Shareholders
3. Dutch Auction
4. Private Negotiation (Green Mail)

7. 16-7
Dividend Payments
Cash Dividend - Payment of cash by the firm
to its shareholders.
Ex-Dividend Date - Date that determines
whether a stockholder is entitled to a dividend
payment; anyone holding stock before this
date is entitled to a dividend.
Record Date - Person who owns stock on this
date received the dividend.

8. 16-8
Dividend Payments
Stock Dividend - Distribution of additional
shares to a firm’s stockholders.
Stock Splits - Issue of additional shares to
firm’s stockholders.
Stock Repurchase - Firm buys back stock
from its shareholders.

9. 16-9
The Payout Decision
Dividend Decision Survey (2004)
The cost of external capital is lower than the cost of a
dividend cut
Rather than reducing dividends we would raise new funds
to undertake a profitable project
We consider the change in the dividend
We are reluctant to make a change that may have to be
reversed
We look at the current dividend level
We try to maintain a smooth dividend stream
We try to avoid reducing the dividend
0 10 20 30 40 50 60 70 80 90 100
Executives who agree or strongly agree (%)

10. 16-10
The Payout Decision
Lintner’s “Stylized Facts,”
as updated by Brav, Graham, Harvey, Michaely (2004)
1. Managers are reluctant to make dividend changes that may have to be
reversed. They are particularly worried about having to rescind a
dividend increase and, if necessary, would choose to raise new funds to
maintain the payout.
2. To avoid the risk of a reduction in payout, managers smooth” dividends.
Consequently, dividend changes follow shifts in long-run sustainable
earnings. Transitory earnings changes are unlikely to affect dividend
payouts.
3. Managers focus more on dividend changes than on absolute levels. Thus
paying a $2.00 dividend is an important financial decision if last year’s
dividend was $1.00, but no big deal if last year’s dividend was $2.00.

11. 16-11
Information in Payouts
 Dividends and stock repurchase decisions contain
information
 The information contained in the decisions varies
 Asymmetric information may be conveyed
 Dividend increases could mean overpriced stock
or increased future profits
 The signal varies based on prior information about
the company

12. 16-12
Information in Payouts
Attitudes concerning dividend targets vary
DIV1 target dividend
target ratio EPS1
Dividend Change
DIV1 - DIV0 target change
target ratio EPS1 - DIV0

13. 16-13
Information in Payouts
Dividend changes confirm the following
DIV - DIV0
1 adjustment rate target change
adjustment rate target ratio EPS1 - DIV0

14. 16-14
Dividend Policy
Impact of Dividend Changes on EPS
Change EPS/Price at t = 0 as %
15
10
5
0
-5
Div Rise
Div Cut
-10
-15
Year
Source: Healy & Palepu (1988)

15. 16-15
Dividend Policy
Before After
Dividend Dividend
New
stockholders
Total value of firm
Each share
worth this
before … … and
worth
this
after Old
stockholders
Total number Total number
of shares of shares
Example of 1/3rd of worth paid as dividend and raising money via new shares

16. 16-16
Dividend Policy
Dividend financed No dividend, no
by stock issue stock issue
New stockholders New stockholders
Shares
Cash
Firm Cash Shares
Cash
Old stockholders Old stockholders

17. 16-17
Dividend Policy is Irrelevant
Since investors do not need dividends to
convert shares to cash they will not pay
higher prices for firms with higher dividend
payouts. In other words, dividend policy
will have no impact on the value of the firm.

18. 16-18
Dividend Policy is Irrelevant
Example - Assume Rational Demiconductor has no extra cash, but declares a
$1,000 dividend. They also require $1,000 for current investment needs.
Using M&M Theory, and given the following balance sheet
information, show how the value of the firm is not altered when new shares
are issued to pay for the dividend.
Record Date
Cash 1,000
Asset Value 9,000
Total Value 10,000 +
New Proj NPV 2,000
# of Shares 1,000
price/share $12

19. 16-19
Dividend Policy is Irrelevant
Example - Assume Rational Demiconductor has no extra cash, but declares a
$1,000 dividend. They also require $1,000 for current investment needs.
Using M&M Theory, and given the following balance sheet
information, show how the value of the firm is not altered when new shares
are issued to pay for the dividend.
Record Date Pmt Date
Cash 1,000 0
Asset Value 9,000 9,000
Total Value 10,000 + 9,000
New Proj NPV 2,000 2,000
# of Shares 1,000 1,000
price/share $12 $11

20. 16-20
Dividend Policy is Irrelevant
Example - Assume Rational Demiconductor has no extra cash, but declares a
$1,000 dividend. They also require $1,000 for current investment needs.
Using M&M Theory, and given the following balance sheet
information, show how the value of the firm is not altered when new shares
are issued to pay for the dividend.
Record Date Pmt Date Post Pmt
Cash 1,000 0 1,000 (91 sh @ $11)
Asset Value 9,000 9,000 9,000
Total Value 10,000 + 9,000 10,000
New Proj NPV 2,000 2,000 2,000
# of Shares 1,000 1,000 1,091
price/share $12 $11 $11
NEW SHARES ARE ISSUED

21. 16-21
Dividend Policy is Irrelevant
Example - continued - Shareholder Value
Record
Stock 12,000
Cash 0
Total Value 12,000
Stock = 1,000 sh @ $12 = 12,000

22. 16-22
Dividend Policy is Irrelevant
Example - continued - Shareholder Value
Record Pmt
Stock 12,000 11,000
Cash 0 1,000
Total Value 12,000 12,000
Stock = 1,000sh @ $11 = 11,000

23. 16-23
Dividend Policy is Irrelevant
Example - continued - Shareholder Value
Record Pmt Post
Stock 12,000 11,000 12,000
Cash 0 1,000 0
Total Value 12,000 12,000 12,000
Stock = 1,091sh @ $115 = 12,000
 Assume stockholders purchase the new issue with the cash
dividend proceeds.

24. 16-24
Dividend Theories
Leftists (M&M) - Dividend does not effect value
Rightists - Dividends increase value
Middle of the roaders - Leftist theory with some
reality thrown in.
Residual Dividend Policy

25. 16-25
Dividends Increase Value
Market Imperfections and Clientele Effect
There are natural clients for high-payout
stocks, but it does not follow that any particular
firm can benefit by increasing its dividends. The
high dividend clientele already have plenty of high
dividend stock to choose from.
These clients increase the price of the stock
through their demand for a dividend paying stock.

26. 16-26
Dividends Increase Value
Dividends as Signals
Dividend increases send good news about cash
flows and earnings. Dividend cuts send bad news.
Because a high dividend payout policy will be
costly to firms that do not have the cash flow to
support it, dividend increases signal a company’s
good fortune and its manager’s confidence in
future cash flows.

27. 16-27
Dividends Decrease Value
Tax Consequences
Companies can convert dividends into capital
gains by shifting their dividend policies. If
dividends are taxed more heavily than capital
gains, taxpaying investors should welcome such a
move and value the firm more favorably.
In such a tax environment, the total cash flow
retained by the firm and/or held by shareholders
will be higher than if dividends are paid.

28. 16-28
Taxes and Dividend Policy
Since capital gains are taxed at a lower rate
than dividend income, companies should
pay the lowest dividend possible.
Dividend policy should adjust to changes in
the tax code.

29. 16-29
Taxes and Dividend Policy
Firm A Firm B
(no dividend) (high dividend)
Next year' s price 112.50 102.50
Dividend 0 10
Total pretax payoff 112.50 112.50
Today' s stock price 100 97.78
Capital gain 12.50 4.72
12.5 14.72
Pretax rate of return (%) 100 100 12.5 97.78 100 15.05
Tax on div @ 50% 0 .40 10 4.00
Tax on Cap Gain @ 20% .20 12.50 2.50 .20 4.72 0.94
Total After Tax income
(0 12.50) 2.50 10 (10 4.72) (4 0.94) 9.78
(div cap gain - taxes)
10 9.78
After tax rate of return (%) 100 100 10.0 97.78 100 10.0

30. 16-30
Taxes and Dividend Policy
In U.S., shareholders are taxed twice (figures in dollars)
Cash Flow
Operating Income 100.00
Corporate tax at 35% 35.00
After Tax income (paid as div) 65.00
Income tax paid by investors at 15.0% 9.75
Cash to Shareholder 55.25

31. 16-31
Taxes and Dividend Policy
Under imputed tax systems, such as that in Australia, Shareholders
receive a tax credit for the corporate tax the firm pays (figures in
Australian dollars)
Rate of Income tax
15% 30% 47%
Operating Income 100 100 100
Corporate tax (Tc=.30) 30 30 30
After Tax income 70 70 70
Grossed up Dividend 100 100 100
Income tax 15 30 47
Tax credit for Corp Pmt -30 -30 -30
Tax due from shareholder -15 0 17
Cash to Shareholder 85 70 53

32. 16-32
Dividend Theories
Residual Dividend Policy
r
MRI = IRR
12 % COC
QTY $$$

33. 16-33
Web Resources
Click to access web sites
Internet connection required
www.earnings.com
www.ex-dividend.com
www.dripcentral.com